Should Investors Fear This Financial Reform?

Are the talks to wind down Freddie and Fannie a major risk to the struggling mREIT sector?

The FHFA is the Conservator of Fannie Mae and Freddie Mac -- two entities with an uncertain future

2013 has been a great year for most stocks. Only 49 companies in the S&P 500 are trading lower so far this year.

However, the mREIT industry has been left in the dust. mREITs, essentially leveraged mortgage-backed security (MBS) funds that receive special tax treatment by the IRS and spit off massive dividends, have been whacked, and more pain could be on the way.

The primary reason for the sell-off of Annaly Capital(NYSE:NLY), American Capital Agency(NASDAQ:AGNC), and Armour Residential(NYSE:ARR), just three of the funds that mainly invest in MBSes backed by Fannie Mae and Freddie Mac, is the fear that the inevitable rise in interests rates will damage firms' book values and further squeeze net interest margins, thus shrinking net income and dividend payouts.

A new risk emerges?While these fears and concerns are valid, especially in a scenario of rapidly rising short-term interest rates and a prolonged "flat" yield curve, should investors be worried about the recent grumblings and potential legislation that would wind down Fannie Mae and Freddie Mac?

In the current state, Fannie and Freddie allow the mREITs purchasing the Agency MBSes to essentially ignore default risk on the securities and focus primarily on managing interest rate risk and prepayment risk (the risk of homeowners refinancing at lower rates and investors having to reinvest at lower rates). Now, a bipartisan effort (yes, many Democrats and Republicans actually agree on something!) is being made to reduce Fannie and Freddie's role of bearing the default risk and shift that risk to private insurers.

In the proposal headed by Democrat Senator Mark Warner from Virginia and Republican Senator Bob Corker from Tennessee (pictured left), similar to the recommendations from the Bipartisan Policy Center made in February, the government would still be in a position to backstop catastrophic losses once private insurance is exhausted; however, the uncertainty of the legalese and market's response could be significant.

The mREITs acknowledge the risk at hand. Annaly Capital states in its 10-K:

Any changes to the nature of their guarantee obligations could redefine what constitutes an Agency mortgage-backed security and could have broad adverse implications for the market and our business, operations and financial condition. If Fannie Mae or Freddie Mac are eliminated, or their structures change radically (i.e., limitation or removal of the guarantee obligation), we may be unable to acquire additional Agency mortgage-backed securities.

A reduction in the supply of Agency mortgage-backed securities could negatively affect the pricing of Agency mortgage-backed securities by reducing the spread between the interest we earn on our portfolio of Agency mortgage-backed securities and our cost of financing that portfolio.

Impact outside of the mREITsThe uncertainty around the Agencies' future is surely an unwelcome headline, but if the government is still the ultimate backstop, there may not be any real change in the risk profile of what would formerly be known as an "Agency MBS." Given the liquidity and "risk-free" profile of these fungible-like securities, their importance to the entire financial system is great.

For example, in 2012, Bank of America(NYSE:BAC) held a roughly $372 billion asset pool which it designated as "Global Excess Liquidity Sources." The bank defines these assets as "high-quality, liquid, unencumbered securities," which it can "quickly obtain cash for ... even in stressed market conditions, through repurchase agreements or outright sales." Of Bank of America's $372 billion, 73% was U.S. agency securities and MBSes.

Not a reason to fretGiven the proliferation of Agency MBSes across the entire financial system, any legislation decision to alter the government's hand in the mortgage market will carefully consider the broader impact on the market. Despite both sides of the aisle appearing to agree on the need for reform, actual changes are surely several years away and will most likely be delayed until the U.S. government has recouped the cost incurred when bailing out the crumbling institutions in 2008.

In the meantime, the noise coming from the volatility of Fannie Mae's common shares and grand bipartisan statements will continue to be just that for the mREITs: noise. The main risk remains management's ability to effectively position the book to avoid drastic short-term dividend cuts and continue to build a sustainable asset base.